The Most Important Stock Investment Lesson I Ever Learned

by: Chuck Carnevale

Summary

Never take investment advice from the market, it often lies to you.

Price volatility is an unavoidable aspect of investing in common stocks.

Here’s how logic and reason can weaken the potential damage of price volatility.

Bonus video: Real-world evidence that stock prices are often pathological liars.

Introduction

My investing career officially started in 1970. However, for several years prior to that time, I was an avid and interested student of common stock investing. My initial lessons were taught by studying the behavior and practices of the most renowned stock investors. Although these academic pursuits taught me a great deal, nothing taught me more than the school of hard knocks. Consequently, the most important lessons I learned were unmercifully taught through real-life experiences. Some of these lessons were hard and even cruel at times. But the hardest lessons learned are often learned best.

The theme of this article is to share with my readers what I consider to be the most important stock investment lesson I ever learned. This important lesson is supported by virtually every master investor that I have learned to respect and admire. This lesson was also emphatically taught to me in the school of hard knocks. However, my motivation to write this is born from the realization that very few "investors" are able to implement this lesson under real-world situations. My anecdotal evidence for this fact stems from the litany of comments I often receive on my articles, as well as numerous discussions with clients over the years.

Additionally, I write this fully cognizant of the reality that very few will be psychologically capable or even willing to heed this important lesson. With that said, this important lesson is actually quite simple even though it is difficult for many investors to embrace and practice. However, if this message resonates with just one reader, then I will feel that my efforts were worthwhile.

The Most Important Stock Investment Lesson I Ever Learned

From a broad or general perspective, this investment lesson is simply to apply the discipline to only take investment advice from credible sources. Unfortunately, it has been my experience that most investors are keen to get their investment advice from pathological liars. Obviously, pathological liars are not a reliable source.

More specifically, this important investment lesson is: do not base investment decisions on stocks based on short-term price volatility. Truly aware investors recognize and accept the reality that stock price movements can be, and often are, irrational in the short run.

Furthermore, I've written extensively on the subject in the past. On February 9, 2013, I posted an article titled, "How To Properly Think About Stock Prices In Today's Volatile Markets." Originally, I intended to title the article "Stock Prices Are Pathological Liars." However, upon further reflection, I was afraid the title might be too provocative. Readers interested in learning more about the most important investment lesson I ever learned might enjoy reading that article as I consider the message timeless. Nevertheless, this speaks to my pathological liar comment referenced above. What follows is my opening paragraph:

"Price volatility is an unavoidable aspect of investing in common stocks. During periods when emotions are dominating reason, price volatility can become more pronounced than is normal during calmer times. The insidious part of this fact is that the more volatile stock prices are, the more fear and stress they generate, which only feeds even greater volatility. Of course, the same can be said when greed raises its ugly head. The purpose of this article is to provide some logic and reason that can be applied to stock price volatility that simultaneously weakens its potential damage."

Price Is What You Pay - Value Is What You Get

Investing wisdom states that the price is what you pay, but the value is what you get. Therefore, determining value is vital to successful investing. As I have stated many times before, value is derived from the future cash flows your investments generate relative to what you pay to buy them. The important point is that value is a relative term.

Investors often rely on calculations such as price to earnings ratios (PE ratios) to ascertain valuation. Unfortunately, two companies with the same PE ratio can have entirely different true values. Even more dangerous is the fact that a company with a lower PE ratio could actually be much more expensive than a company with a much higher ratio. It's all relative to the company's future cash flow/earnings generation.

Shout out to Vishal Khandelwal

Vishal Khandelwal is a fellow Seeking Alpha contributor that I am proud to be a follower of. He has been posting articles since 2015, and much to my chagrin, he has only 320 followers. However, Vishal is also the founder of SafalNiveshak.com, a website dedicated to helping small investors become smart, independent, and successful in their stock market investing. According to his profile, his website Safal Niveshak (Hindi phrase for successful investor) has grown to a community of 12,000+ dedicated readers. Therefore, I am happy for that success, but unfortunately, I believe that too many Seeking Alpha readers are apparently missing a great source of investing wisdom.

In conducting research for this article, I came across a special report that Vishal produced titled "30 Big Ideas from Seth Klarman's Margin of Safety." For those unfamiliar with Seth Klarman, he is the manager of the renowned value investing shop Baupost Group and the author of the value investing classic "Margin of Safety, Risk-Averse Investing Strategies for the Thoughtful Investor."

The 5th big idea Vishal offered relates specifically to the theme of this article and is presented as follows:

"Don't seek Mr. Market's advice.

Some investors - really speculators - mistakenly look to Mr. Market for investment guidance.

They observe him setting a lower price for a security and, unmindful of his irrationality, rush to sell their holdings, ignoring their own assessment of underlying value. Other times they see him raising prices and, trusting his lead, buy in at the higher figure as if he knew more than they.

The reality is that Mr. Market knows nothing, being the product of the collective action of thousands of buyers and sellers who themselves are not always motivated by investment fundamentals.

Emotional investors and speculators inevitably lose money; investors who take advantage of Mr. Market's periodic irrationality, by contrast, have a good chance of enjoying long-term success."

Focus On the Underlying Business

I believe that it is imperative to be conscious of the fact that investing in a company (stock) is not analogous to buying a lottery ticket. True investors understand that there is an underlying business that they are purchasing. And even more to the point, true investors understand that their rewards will come through the success of the business they now own and not through a fickle auction market. Therefore, rather than worry about short-term price volatility, true investors place their attention on understanding the merits and potential of the business they have invested in. To me, this is the essence of being a true investor.

So the key is to think and act like a business owner when you purchase a stock. When someone invests in or starts a new business, they are not thinking about selling it in the next day, month or even year. Instead, they are thinking about owning and running the business for years to come. Of course, if the business is privately held, there is also the benefit that no one is continuously shoving purchase quotes in their face either.

It's critical to understand and remember that short-term price volatility is not always rational and, certainly, not always fundamentally based. Instead, short-term price volatility is more often than not emotionally charged. Consequently, a rising stock price is not always indicative of a good company, but sometimes it can be. Conversely, a falling stock price is not always indicative of a bad company, but sometimes it can be.

The secret is to have a realistic assessment of the true value of the business you own, and make your buy, sell or hold decisions accordingly. The primary point is to focus your attention on how you think the business will perform going forward. In the long run, stock price will inevitably relate to business results. In the short run, fear or greed can drive the price up or down unjustifiably. And most importantly, short-term price aberrations are totally unpredictable. Therefore, you cannot, and I argue should not place too much importance on them.

In the long run, stock prices will correlate very closely to the success of the business behind the stock. Therefore, if you are a prudent long-term oriented investor, it only makes sense to focus more on business results (fundamentals) than it does short-term price action. The reason I consider this the most important stock lesson I ever learned is because it allows me to make rational decisions in the face of emotionally charged periods of time.

More simply stated, it provides me the ability and the capacity to recognize aberrant valuation levels when they manifest. When a stock is overvalued based on the company's business results, that is what I see. I do not see a good stock, I see an overvalued stock. Conversely, the same holds true with undervaluation. When I see a great business being misappraised by the market, I see opportunity where others see risk. These perspectives empower me to make sound long-term decisions. Consequently, I rarely sell when I should buy, and I rarely buy when I should sell.

When all you see is price action, you can be easily misled. Furthermore, I believe that ascertaining a reasonable idea of the value of a business is significantly easier and more reliable than trying to guess where its price might go in the short run. You might not be able to do this with perfect precision, but you can certainly do it within a reasonable enough range of accuracy.

Furthermore, there is an additional benefit of focusing on fundamentals over price action. Stock prices trade (fluctuate) virtually every minute of every hour of every day that the market is open. Sometimes price volatility can be extraordinary. Simply search for "top gainers and losers" on most any financial website and you will see stock price percentage changes that are often quite large. Common sense would dictate that a business cannot be worth 10%, 20%, 30% or even 50% more or less than it was the day before. The only logical conclusion is that the market is inaccurately pricing the stock today or it was inaccurately pricing the stock yesterday. The value of a business simply cannot change this much over such a short period of time.

In contrast, businesses (stocks) only report financial results quarterly. Consequently, there is less opportunity to have your emotions played with. Unless, of course, you are foolish enough to pay attention to any or all of the noise that happens in between financial reporting periods. To summarize, I have trained myself to only focus my attention on the actual financial results of each company I am investing in. Rather than get all flustered by opinion, I prefer facts over fiction.

Stock Prices in the Real World: F.A.S.T. Graphs Fundamental Analysis

When considering investing in any stock, I believe it is imperative and quite useful to have a clear perspective of how the business behind the stock has fundamentally performed over time. The only way to accomplish this is to review the company's historical operating results. Additionally, I believe it is also quite useful to evaluate how the market has historically valued that fundamental performance. Armed with this information, I believe that more intelligent investment decisions can be made.

Therefore, the following video will examine the business performance based on the normal price to EBITDA (earnings before interest, tax, depreciation and amortization) of 11 businesses. I offer this exercise in order to provide real-world evidence that stock prices "are not always motivated by investment fundamentals" as Seth Klarman postulated above. In simple terms, over the short run, stock prices are often pathological liars. I believe this exercise will clearly illustrate the undeniable reality that stock prices do not always reflect the true worth of a business in the short run. Additionally, I believe this exercise will also illustrate how long-term price performance is functionally related to business results.

Summary and Conclusions

I believe that investing is best done when it is done from a long-term perspective and objective. Buying stocks with short-term expectations falls more into the category of speculating than it does investing. Stock prices are fickle and unpredictable in the short run. Business results are more reliable and more predictable. However, that doesn't mean it is easy, but I believe it is certainly more intelligent than attempting to forecast stock prices.

But perhaps best of all, evaluating a company's stock price based on its fundamental value can certainly help investors avoid making obvious mistakes. It is impossible to invest in common stocks and never make a mistake. However, it is quite possible to avoid clear mistakes based on egregiously inaccurate appraisals of a business's true worth. Never let Mr. Market dictate your behavior. Invest wisely instead.

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Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: I am/we are long ABC, CSCO, DIS, HD, SCG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.